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Advisors should re-examine clients’ coverage and plans in light of Munich Re’s report

This is an extended version of the article that appeared in the February 2013 issue of Investment Advisor.

Just a few days before Hurricane Sandy barreled up the East Coast, German reinsurance giant Munich Re issued a new report titled “Severe Weather in North America” revealing that, despite notable recent events such as epic flooding and wildfires in Australia and the inundation of whole regions of Asia by rain, weather disasters have hit North America far harder than they have the rest of the world. Citing data that revealed a fourfold increase in natural catastrophes in North America since the early 1980s, the report focused not just on the damage such storms wreaked and its cost, but also on the need to change both insurance and mitigation strategies.

Advisors might want to check it out and then have another look at their clients’ assets—not just portfolio holdings, but businesses and residences as well. Otherwise, changes in both underwriting and mitigation strategies could end up sending clients down different paths in ways neither you nor they have anticipated, both in the handling of their businesses and in their choices for residential and vacation properties.

Advisors with clients on the East Coast of the United States are already familiar with the increasing difficulty of finding coverage for homes and businesses in the path of hurricanes, spurred by the onset of Hurricane Andrew in 1992. The Gulf Coast in particular has seen its share of hardship caused by hurricanes, and insurers have felt the pain as well. According to the report, “Underwriting windstorm risk in the Gulf of Mexico in recent years has been a very volatile process […]. Underwriting windstorm insurance in the Gulf of Mexico has been an exercise in capital destruction over the last 10 years.”

The report also noted, “Natural catastrophe losses for personal lines in the United States have risen dramatically in recent years, largely due to socioeconomic changes that have increased loss potentials.” With a population heading either south or toward the coast, more and more people are in harm’s way from massive thunderstorms and from the hurricanes that plague the East Coast with increasing fury.

The migration has been so massive that “[o]ver 50% of the U.S. population now lives in counties directly on the coast where they are vulnerable to powerful winter storms or hurricanes […]. Extensive suburban and exurban sprawl […] has essentially created more ‘targets’ for natural events to potentially hit. Rising home and personal property values over this time period have also contributed to increasing catastrophe losses.”

So it’s hardly surprising that reinsurers should be considering all the ramifications of such increases with an eye toward control. And after defining the terms of the studies, that’s what the report dealt with.

Munich Re classified natural perils, nearly all of which are increasing in frequency, into nine categories: winter storms, tropical cyclones (hurricanes), thunderstorms, inland floods, landslides, subsidence and heave, heat waves and droughts, wildfires, and natural perils in Canada—a whole separate category. Earthquakes and volcanic eruptions and the landslides they cause, which are not on the increase, are not included in these perils.

Risks were categorized as climate variability and change, exposures and vulnerability. The report pointed out that socioeconomic change has contributed substantially to the increase in weather-related events, thanks to the growing density of population in both urban areas and areas prone to atmospheric hazards. However, it also said that the increasing frequency of weather events—thanks in part to anthropogenic climate change, which has affected regional and local climate—has also had an impact on the escalation of risk.

The report defined risk as hazard times exposure times vulnerability, pointing out that a major storm in an uninhabited area will not result in a catastrophe, nor will a major storm in an area that has prepared well for the event. However, in places that have not prepared, “even a moderate storm may cause a devastating catastrophe.” In the first instance, the storm hazard is highest; in the third instance, the storm risk is highest.

Since hazards are the least able factors in risk to be affected—except, said the report, by working in the area of anthropogenic climate change—insurance companies will be focusing on exposure and vulnerability: areas in which those who seek coverage will experience changes.

One fascinating section dealt with testing run by the Insurance Institute for Business & Home Safety (IBHS) to determine how much can be done structurally to protect both commercial and residential buildings from damage due to wind, flooding and fire. Construction techniques that resulted in substantially less damage (and correspondingly less expensive repair or replacement) were shown to be relatively inexpensive.

Wind tests of home construction that compared a home “built to conventional Midwestern construction standards based on field surveys of typical wood frame construction practices in Illinois” to one built instead “to the IBHS fortified for Safer Living Midwest standard” found that the fortified standard added 2.3%–3.8% to the cost of construction, depending on fluctuations in the cost of labor and materials.

However, after the second of several wind tests, repair estimates were sought from two insurance companies and a contractor. While Company 1 said it would cost $6,915 to repair the conventional house, Company 2 estimated the cost at $5,690. The contractor came in at $5,660, and the cost estimates to repair the damage to the fortified home ranged from $3,924 to $4,945 lower—a pretty impressive difference. The conventional house, by the way, was new, while the fortified house was repaired after the first wind test. The conventional house in the first test had been destroyed.

Similar tests were conducted on ways to make buildings more able to survive fire and flood, and they too revealed the potential benefits of both design and materials when building structures in areas prone to such natural disasters.

Still, mitigation can only go so far. Risk-appropriate premiums are in store, and may weigh heavily on those in coastal areas, as well as inland areas prone to regional flooding, heavy thunderstorms and the twin hazards of drought and wildfire. But that’s not all. The combination of changing climate conditions that bring higher losses and the growth of exposure to risk, “viewed from an insurance perspective […] result in increased loss levels, which will need to be reflected in increased, risk-adequate premiums. However, this is not a sustainable model. Clearly, from a risk management perspective, it is of crucial importance to learn about this risk of change and find mitigating solutions.”

One solution is for more appropriate exposure: namely, denial of approval to build in inappropriately risky areas. With insurers working together with government—and remember, the insurance industry was responsible for the first building codes as a means of reducing risk from fire—both individuals and businesses may eventually find themselves denied the opportunity to put themselves, and their assets, at risk.